Triple Threat Retirement Investing: 401k vs. IRA vs. Taxable Brokerage Account

In the United States many employers offer a 401k plan as a benefit to employees.  We are assuming that you are already enrolled in a 401k plan, and contributing at least the minimum amount needed to get the full amount of any employer match (if not, check out the New Investors link on the sidebar).  But with limited investment choices and high fees typically associated with 401k plans, should you be contributing more than what it takes to get the maximum match from your employer?  It depends on how much you plan on investing.

After contributing the minimum percentage needed to get the full employer match in the 401k, the next step is to contribute to a Traditional or Roth IRA, up to the maximum allowed.  Both 401ks and IRAs have tax advantages, but the difference is you can generally pay much less in fees with an IRA.  We wouldn’t recommend contributing more than the minimum amount needed to get the full employer match in the 401k unless you will be maxing out your IRA for the year, because the fees really add up over time.  For example, if you contribute $5500 a year to a 401k and have a 10% return each year for 20 years (with additional 1% in “expense ratio” fees), you will have paid over $38,000 more in fees compared to an IRA with the same return over the same time period (assuming 0.04% in fees).  Using the same example, but over a 40 year period, the fees will add up to $500,000 (the balance of the IRA would be $2.4 million vs. $1.85 million for the 401k).  Since 401k plans vary, it’s worth looking at the actual investments available in your plan and the fees associated with them.  You can open your favorite spreadsheet program and calculate the fees that you could be paying based on your own circumstances (fee % in your 401k investments, number of years until retirement, amount invested, etc.).

So if you are maxing out your IRA for the year, should you contribute any additional money to a 401k or just open a separate brokerage account to avoid the fees?  The tax advantage of a 401k needs to be considered.  Using the 25% tax bracket as an example, if you contribute $18,000 to a 401k, it’s like only spending $13,500 of your money due to the tax savings (and $4,500 of the “government’s money”).  So for the same net cost, you can put $18,000 into a 401k or $13,500 into a separate brokerage account.  Assuming a 1% fee for the 401k and otherwise the same performance of the investments, you will still come out significantly ahead with the 401k over a brokerage account.  However if the 401k investments available to you are not so good, you can be looking at a 2% or greater difference due to worse performance and high fees.  In that case, the brokerage account would be better after around 25 years (using 10% returns for the brokerage vs. 8% for the IRA).  Since we’re talking about potentially hundreds of thousands of dollars difference, it really is worth spending some time to perform your own calculations based on your own circumstances.